F&H Corp. continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H’s CFO:
We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8% on investment. That’s a far better return than F&H earns on its cash holdings.
The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4% rate of return.
a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities? Why or why not?
b. Is F&H’s opportunity cost of capital 4%? How in principle should the CFO determine the cost of capital?
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